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What Are Netflix's Strengths and Weaknesses?

Many people are watching Netflix's (NASDAQ: NFLX) stock head into the stratosphere, leading to a mania of momentum buying. Unfortunately, this sort of momentum often bypasses the fundamentals of the company. Let's do an old fashioned SWOT analysis to examine the strengths, weaknesses, opportunities, and threats that the company faces.

Strengths

Brand: "Netflix" is fast becoming a verb in today's society. Everyone knows the company's name, and the association is generally positive.

Platform: Of all the major streaming services, Netflix has the best delivery system; this helps to keep customers loyal. Amazon's search engine for Prime Video (videos available for free streaming as part of the Prime service that also includes free two-day shipping on all Amazon orders) returns results including videos you have to purchase, Hulu Plus is jumpy and the experience is weighed down by in-show advertisements, and streaming on Time Warner's (NYSE: TWX) HBOGo is both jumpy and plagued with little things like the title of the episode in your queue being unavailable.

Content: While Netflix recently lost Viacom content, it will soon be replaced with content from Disney which will include George Lucas' beloved "Star Wars" franchise. Also, Netflix has sponsored an exclusive window on some pretty good shows, including its hit original production "House of Cards."

DVD margins: Yes, some people still rent DVD's. This helps make up for some of the content unavailable via streaming. While HBO won't be allowing "The Sopranos" to stream via Netflix any time soon, you can still get the series from Netflix on DVD. The DVD service boasts strong contribution margins of around 50%.

Price: Paying $7.99 for all-you-can-watch streaming video is cheaper than one night out at the movies. With Internet-ready TV's dropping like a rock in price, the Netflix experience becomes even more appetizing.

Forward-thinking management: Say what you want about Reed Hastings, he set Netflix up for the streaming environment we're seeing now. He has also brokered some sweetheart deals from content providers who were all too happy to monetize shows that they never imagined would see air time again.

Weaknesses

Valuation: Netflix trades at over 100x forward earnings estimates of $3.52. When you can buy a company like Google (NASDAQ: GOOGL) with $50 billion in cash on the books at 29x current earnings (which still isn't cheap by traditional standards), it makes purchasing Netflix stock difficult to justify.

Quixstergate: Trying to raise prices didn't sit well with consumers and caused Netflix stock to stumble. The effect of this going forward will be to make management a little gun shy at raising prices any time soon. If explained well to consumers given the company's new content, though, Netflix could likely get away with small increases.

DVD subscriber base: In the second quarter, Netflix lost 475,000 DVD subscribers; this left the subscriber base at 7.51 million. Netflix expects that DVD subscriptions will continue to fall until they're zero.

Show ownership: Netflix outbid everyone for "House of Cards" and other Netflix originals. Unlike Time Warner, however, the company doesn't own these shows. Netflix has an exclusive window to stream the show, but after that, poof, the hit might be gone. Time Warner derives residual income from sale of its shows' DVDs and other ancillary benefits that Netflix does not.

Opportunties

International expansion: Beginning solely in the U.S., Netflix is currently available in Canada, England, Netherlands, Scandanavia, and much of Latin America. Netflix will continue to invest in new territories/opportunities.

Raising capital: With people willing to pay this much for Netflix stock, the company might do well to sell more shares. This might be a good move even if it dilutes the holdings of existing shareholders.

Advertising: I'm not necessarily talking about in-show advertising like Hulu uses, as that likely wouldn't go over well. Netflix could use a lot of the white space on its website for banners of products that would be synergistic with its business, however. Examples would be the aforementioned Internet-ready TV's, Google's Chromecast device, or other synergistic technologies. This would be a painless way for the company to increase revenues.

Threats

Off-balance-sheet liabilities: Do your homework! In what may or may not be accounting shenanigans, Netflix has "unfundedcontent liabilities and commitments off the company's balance sheet. Because while Netflix discloses just $2.4 billion in total content liabilities (or 69% of total liabilities), it is the massive $3.3 billion in off-balance-sheet liabilities, up half a billion in just one year, that is truly disturbing."

Google: Google already owns YouTube, which it has successfully monetized. Google has also put the industry on notice that it plans to add premium content channels, having forged deals ranging from the Hollywood elite to the Wall Street Journal. The company has put a $200 million arrow behind the venture and could easily pull eyes away from Netflix.

Content price: As mentioned above, Netflix was the beneficiary of very good content deals when streaming began. Expect media companies to raise prices and squeeze Netflix's margins.

Final thoughtsWhile I am a Netflix subscriber, the valuation on its shares is simply too high. Warren Buffett says rule no. 1 of investing is "don't lose money." Rule no. 2: "follow rule no. 1." With a forward P/E in excess of 100, there are simply far cheaper and less risky companies that one can buy. I would look for a 50% pullback before even considering an investment, and that's without delving into the mysterious off-balance sheet figures. Stay away from Netflix at these levels.

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Comments from our Foolish Readers

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This was really helpful overall, and I agree with your final thoughts. I've been a long-term uber-bull, and even I would not be a buyer today. I'm definitely holding for the long-term, and there is not much that would dislodge me from my positions.

I just have a couple comments/questions:

Strengths:

- Their technology DNA. They are at heart a bunch of geeks. They love data. They love making tools. They love analyzing the data and making predictions - what will their subscribers love to watch, and so what should they invest their programming $$'s in? I believe this is an immense strength which they've used to dig a deep moat around their business.

- Their subscribers, both absolute numbers and their growth rate. Their subs base (>30MM US subs) gives them a huge advantage in negotiations, and is probably the reason Disney has entered into a number of exclusive agreements with NFLX. Their phenomenal growth rate lets them invest even larger amounts of $$s into programming while keeping their subscription price low.

- Learning organization. The Qwikster debacle should actually show up here as a strength - because it demonstrates the ability of the management to make a mistake and to quickly fix it, rebound from it, get back to performance (subscriber growth) - and hopefully not make the same mistake again.

- Focus - NFLX does only one kind of product: a subscription-based all-you-can-eat movie/TV network. They don't do live broadcast, sports, pay-per-view, or sell garden rakes. Which means they can be extremely good at what they do.

Weaknesses:

- is valuation at any price any kind of a weakness? A business is fundamentally not affected by stock price. A good business shouldn't even bother watching the stock price. Their eyes should be on customer/stakeholder metrics - the stock price should follow their business performance which should follow their happy customers/stakeholders. (Stakeholders include 1st customers, 2nd employees, 3rd community,... and very very last shareholders)

- I think the Qwikster fiasco is an event - not a weakness. And actually, I think it demonstrates a strength of NFLX - the ability of the management to learn - see above.

- Focus - the focus I mention above as a strength can also be a weakness - since it means if this is not the correct model going forward, then NFLX is toast unless they can be agile and make a complete product change. A great example of a company making a huge strategic product change is Intel when they went from memory to microprocessor chips. Will NFLX have to make a similar change? Very very few companies can survive having to make such a change. Witness the cable operators who, despite the classic example of the music industry's death at the hands of APPL's iTunes, cannot for their very survival make the change to a viewer-centered internet distribution model more like NFLX. A great example of a company well positioned if PPV is the correct model is AMZN, who does both PPV and subscription (Prime). But look where they are in terms of video viewers - 1/20th of the streaming traffic compared to NFLX.

Opportunities:

- mobile - data shows that NFLX traffic on small screens is tiny. That's an opportunity for huge growth.

Threats:

- Aren't threats supposed to be competitors and other external risks to the company? So the off-balance-sheet liabilities (if they are a real problem) should be a weakness, not a threat. It is a possible internally generated company weakness. Minor nitpicking there. Google and content prices are definitely threats.

Well sure Ace, one way to interpret what happened here is that the author had a strong preconceived conclusion (NFLX is way too expensive as a stock and is playing unacceptable accounting games) and then filled out a SWOT to support those conclusions. That's possible.

But another more interesting possibility is that they did a SWOT to see whether there is a reasonable thesis to support making an investment - and based on what they filled out they concluded that the risks outweigh the benefits. So this made a good opportunity to debate the SWOT issues, show what was left out, and demonstrate that from a *qualitative* assessment of the company (which is what SWOT does), NFLX is in a very strong position.

The problem, of course, is that the two concluding issues the author brought up, price and accounting practices, are either not a normal part of a SWOT, or should be automatic disqualification for consideration. Stock price is what you are willing to pay for a company which you have analyzed by SWOT, assuming it comes out positive. And if there are accounting irregularities, you should automatically toss the company in the trash.

So it is possible that the SWOT was an just an afterthought to support a strongly held conclusion. But it is more fun to debate the details and show the other cards (like the strengths that were not even considered), than to debate the possible intents (who's a mind reader?).

I think the SWOT was very incomplete and inaccurate, but I agree with the price concern, though not with the accounting concern.